The traditional argument for index investing – such as through exchange traded funds – is based on the view that most active managers fail to beat their respective investment benchmarks more often than not. But while this may be true to some extent, it’s clear that some active managers maintain good track records over time and are favoured by some investors. Given this reality, this note demonstrates how even in cases where successful active managers can be found, passive investment strategies as part of a “core/satellite” approach can still play a useful complementary role. Indeed, this highlights a broader point: the choice between active and passive investment strategies need not always be mutually exclusive, but rather each should be seen to complement the other.

One traditional approach to investing, for those that use managed funds, involves deciding what percent of one’s portfolio should be allocated to a certain asset class (the asset allocation decision), and then deciding on which active fund managers should be employed to generate the best returns possible within the asset class (the investment manager decision).

For example, as an investor you might decide to allocate 60% of your portfolio to Australian equities, and assign one third (or 20%) of this 60% allocation to three different active managers. Each active fund manager would be expected to, at least, provide returns that matched the market, plus a little extra in terms of “alpha” return. You’d then watch your portfolio carefully and swap funds when and if you thought that one of them was not meeting your requirements, or you had a specific new investment theme (for example resources or global markets) that you wanted to pursue. Such a portfolio is depicted below:

By contrast, as we have previously discussed in relation to shares, a “core/satellite” approach aims to separate the “alpha” and “beta” investment returns within a portfolio. In the current example, a core/satellite approach would involve using index funds (such as through ETFs) as a core asset class holding to at least lock in “beta” returns from the market, and then adding a few actively managed funds for extra “alpha” returns. Referring to the case above, instead of spreading your 60% equity portfolio allocation across three active managers, you might invest 45% in an index fund and then give 5% to each of the three active managers above. Such a portfolio is depicted below:

But what explicit benefits does this approach bring?

For starters, it can help to reduce management fees. By buying into an actively managed fund, you might be paying a high management fee to a manager even though a good chunk of their return is only beta. You might instead get this beta return with a lower cost index fund. As seen in the table below, if all three active funds charged a 1.2% management fee, and an equity index fund only charged only 0.40%, then the core/satellite portfolio would have an average management expense ratio (MER) 0.3pp lower than the traditional portfolio.

The core/satellite approach also allows more granulated risk control. By investing in an index fund, you know exactly how much of your portfolio will track the market. With active funds you never can be too sure, especially if the fund’s senior managers and/or investment strategies change.

Also worth mentioning is that core/satellite investing can save on transaction costs if you decide to swap active managers. Under the traditional portfolio, if you find one of your active managers consistently lagged the market, then selling it for something else would involve turning over 20% of your portfolio. But if, due to a larger index fund holding, the active fund only accounted for 5 per cent of the portfolio, then making the change only involves turning over a much smaller share of the portfolio – with lower transaction costs to pay. The core equity holding need never be sold until such time as your overall asset allocation preference changes.

Last but not least, by allocating less of your portfolio to active management, you are in a better position to be more discerning about the active fund managers you consider. With a core/satellite approach, there’s less need for index hugging active managers – and greater scope for more truly active funds that may produce greater short-run volatility in returns but potentially good market beating long-run performance. Indeed, to the extent the short-run returns from these satellite funds are less correlated with overall equity market returns, it’s conceivable overall portfolio return volatility could be reduced.

In short, using a core/satellite approach when investing helps separate out the beta and alpha components of your portfolio’s investment return. You no longer need to over pay for beta performance, and you can afford to be more selective in seeking out the true alpha generators in the market.

1 Comment

The core part is suboptimal and can be very risky. It is cheaper for a reason, and is not well aligned with most investors’ risk and return preferences. It is often harshly accused of being “dumb investing”. However, when index investing is used as it is usually it may be better thought of as “naive or lazy investing”.

Good investing usually relies upon careful due diligence and thoughtful consideration, to have the best chance of being successful.

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